ECONOMICS IN 2006
World economic growth should be reasonable in 2006. China, India, Russia, and Brazil will continue to grow at a rapid rate and continue to push the global economy. Every year Cassandra’s call for a melt down in China, and every year they are wrong. Where is the evidence? China recently revised up its GDP growth for the first nine months of 2005 to about 11%. This is strong by any measure.
The U.S. economy should grow at a moderate rate despite the end of the U.S. dollar rally. Europe and Japan on the other hand, should grow their economies at a faster rate than in 2005, but not as fast as the U.S.
Altogether global growth will continue to be strong. Much of this growth, especially in the U.S., will be politically driven. President Bush is in trouble and he will pull out all the stops to assure that the Republicans do not lose control of Congress in the November 2006 election. This means the politicians will continue to create liquidity and Fed Chairman Bernanke will probably acquiesce. The result is marginal economic growth in the U.S., and the probability of bigger trade, balance of payments, and budget deficits than ever.
We do not see a lot of risk in holding companies, which are benefited by high global liquidity. As we have been saying for several months. Money is flowing out of real estate and into many markets, including stocks, commodities, and currencies. However, not all stocks are attractive.
GOLD WILL BE A BIG PLAY IN 2006
If the dollar peaks (which we believe that it has already peaked versus some currencies), or if inflation rises (as we believe it might do to a small degree) gold will benefit. Today, at $505 an ounce, Gold is 40% below the level it reached in 1980. That was 26 years ago. In the last few year’s gold doubled but the big gold mining stocks have only gone up 200%. If gold goes up only 20% in 2006, I expect the gold mining companies to rise at a much more rapid rate. As we all know, once the fixed costs and the high costs of production are cleared, gold mining is a very profitable enterprise.
THE BIG PLAYERS ARE STARTING TO ACCUMULATE GOLD
In recent weeks I have been receiving calls from some of my market professional friends and contacts about how to purchase gold for their multi billion-dollar portfolios. They tell me that, it is their intention to hold about 5% of the pension fund, mutual fund and hedge funds they manage in gold shares. I believe that the reason that gold shares are outperforming the metal is the entrance of professional money in large size into the share market.
Interestingly enough, a few days ago a large European brokerage firm did a survey of their institutional investor clients. The survey revealed 70% of these investment managers said, that they would buy gold and gold shares for 5% of their portfolios, over the next 3 years. This is huge news. The total market value of the publicly traded gold shares is small. If these giants carry out their promise, and put 5% of their money in gold shares, the shares will rise a great deal in the next 3 years just to accommodate the institutional investors buying.
STOCKS SHOULD DO WELL IN 2006:
U.S. AND EUROPEAN STOCKS
In general, we favor financials, commodities and a few technology companies. More specifically, we like stock brokerages, which will get new underwriting and merger fees. Also, reinsurance companies, who are raising premiums and have much of their recent hurricane losses already announced, could get new investors. What we also see as attractive are the shares of commodities firms that produce gold and other important industrial metals and the machinery companies whose products are used to mine the minerals. Lastly, a number of technology companies appear attractive.
The key to industry attractiveness is pricing power. Commodities have pricing power because global demand is in balance with supply. Manufacturing in the areas of strong demand like oil field equipment, mining equipment, and transportation equipment have pricing power. Also, some services like oil field services and medical services have pricing power.
We believe that energy, our most important focus for the last 3 years, will have a year of price consolidation. We know that politicians see lower gasoline and heating oil prices as key to their election possibilities, and they want to lower them to win votes. Incumbent politicians also want the stock market to rise in 2006. They will continue capital gains tax cuts to encourage increases in liquidity, in order to curry favor with investors and thus to create better voter psychology.
We especially like Hong Kong real estate companies where real estate prices remain cheap, rents are growing and occupancy rates are in excess of 95%. We do not like Chinese real estate, however, where the accounting is flaky, and the government can change the rules anytime. Consequently, we are only buying in Hong Kong, which has a western tradition of law and accountancy that is relatively honest.
We continue to believe that the Japanese market will end 2006 higher than today, and maybe a lot higher. Remember, the Nikkei Index peaked in 1989 just shy of 40,000. Today, it is just shy of 16,000. That means it has to go up 150% to get back to the level of 16 years ago. In the last 16 years the Japanese economy has grown by about 40%. Corporate profits have risen and the market’s PE ratio has fallen by about two thirds. The Japanese market PE is now very reasonable especially considering their accounting conventions and historical precedent.
Japan is cleaning up a lot of their mistakes. The old system of cronyism is giving way to progress, and spending on wasteful projects to buy the rural vote has ended. The banks are getting cleaned up. The Japanese have developed a very sophisticated relationship with China where they manufacture most of their goods. This is also demonstrated by the fact that 100,000 Japanese live in Shanghai alone. They are there to move the Japanese industrial machine into China and to make it grow.
Japanese design and Japanese management of the production process and Chinese labor costs seem like a great combination to me.
India looks like it could be a good area for 2006 as well. The country has a ton of potential and a whole lot of smart people. The problem is that those people have varying degrees of business ethics. One must be careful in India. We favor asset plays in India and look for companies with assets in excess of market value. Indian growth stocks that trade in the U.S. are overvalued. Also, there is difficulty in accounting transparency with stocks that trade in India. We like India, but are always cautious when investing here.
LATIN AMERICA HAS PROBLEMS
The big story in Latin America has been the leftist president Hugo Chavez in Venezuela.
As of a few days ago, Bolivia has a Marxist president as well. Chavez is throwing his weight around, and the middle class technocrats who run the businesses and industrial companies in Venezuela are leaving. The spread of Chavez’s influence, and his close relationship with the failed economic policies of Marxism and radical socialism does not make for a fertile investment climate. In fact, the Venezuelan stock market is down a horrendous 35% in 2005. This is the worst stock market performance of any good-sized market in the world.
Now Chavez has made another blunder. In order to buy influence in the region, he has bought the debt of countries like Argentina and Ecuador. He used his countries oil revenues to buy $1 billion of Argentine debt. It substantially understates it to say that these are risky investments. In essence Chavez is holding some of Venezuela’s reserves in emerging market debt. Often this stuff goes bad, and the borrowers stop paying their interest and principle. Maybe he wants it to go bad so he can force his political and economic views on them when they cannot pay. I think the tension caused by the eventual failure of this debt will cause major tensions between Venezuela and those whose debt they own.
It can be argued that money will flow from countries like Venezuela, Peru, and Bolivia into countries where more rationality prevails, such as Mexico and Brazil. This may be true, but I believe that the Chavez problem will cast a pall over much of Latin America. We are not optimistic about this region.
In 2006 we like gold, European and U.S. financials, commodities, and some tech. In Japan, we see a favorable outlook for financials and export companies. In Hong Kong property companies make sense. Finally, in India we like companies selling for low price to asset values.
Watch oil and energy for a buying opportunity when prices come down probably in late summer or fall at this point we will repurchase energy, and then hold on.
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You can also read Monty Guild’s past periodic market and economic commentary articles by going to the Commentary Archive on our web site www.guildinvestment.com.
Monty Guild is Chairman and CEO of Guild Investment Management, Inc., a registered investment advisor. All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice.